The new BHP emerges from the failed US shale adventure
For ASX investors, BHP Billiton shares have emerged as a frontline exposure to the US-China trade conflict, which explains the recent retracement below $31 after the earlier April-June rally priced in the benefits of divesting the non-core US shale assets. The softness in the share price should get the attention of value investors as the market’s generalised fears about the trade dispute, and some likely temporary disappointments in the 2018 result, are clouding an otherwise attractive investment story at the world’s largest miner.
Notwithstanding the escalating rounds of retaliatory new tariffs, it is clear neither the US nor China wants a damaging trade war. We are seeing a public negotiation where each side wants a settlement, judging by several attempts by both sides to reach out and meet/negotiate. An agreement would likely see a sharp rerating of risk assets exposed to China – like BHP shares. One step to an agreement is to find an outcome that makes the US President look good and enables the Chinese authorities to save face. These intangible interests are priorities as much as changes to trade policies, so an agreement might be easier to reach if each side understands the other’s need for domestic approval.
But even if the dispute extends and worsens, we think the market is exaggerating the effects on Chinese demand for the iron ore and coking coal BHP supplies. Most Chinese steel is used by the real estate development and infrastructure construction sectors, not exporters to the US, and these sectors’ drivers are mostly internal. There is a long-term correlation between the amount of land bought by Chinese developers and commodity prices; lately the two series have diverged due to short-selling by hedge funds playing on investor fears about the trade dispute, but we see commodity prices reverting higher to resume their long-term correlation.
Another commodity out of favour during the trade conflict is copper, which contributed 28 per cent of BHP’s 2018 cash earnings. Short positions in copper are at six-year highs. Here the hedge funds are exploiting copper’s reputation (not entirely deserved) as a leading or coincident indicator of world growth, supposedly threatened by US-China attacks on free trade. However, the post-June bear market in copper prices and the amount of shorting are inconsistent with the reality of the copper market, where inventories are exhibiting normal seasonal behaviour and a longer-term supply shortfall looms. There are not enough new large copper projects to meet world demand as electrification continues, renewable energy projects roll out and electric vehicles take an increasing share of car markets. In August EVs rose to three per cent global share, which is still niche but growing each quarter. We see a short squeeze in copper as short positions unwind in the face of reality.
The benefits of exiting US shale (higher return on equity, less earnings volatility, $10.9 billion of capital management) are well-understood but the benefits of what BHP does next with the management time liberated by the divestment are not. Here the inherent expansion options in BHP’s portfolio of large tier one assets are about to get the attention of management and the market. We see the current lack of detail as a preference for a highly conservative approach to disclosure that will soften as organic growth projects emerge, after which they should be included in valuations. Here we refer to the hidden projects implied by the maintenance of capital expenditure at $8 billion even after US shale is divested, smaller latent capacity expansions and debottlenecking initiatives across the group, and larger growth options in Gulf of Mexico petroleum, Australian LNG and South Australia’s Olympic Dam mine.
Sell-side commodity price assumptions always seem to play catch-up to actual prices. The next round of updates in the first half of October is likely to see upgrades to iron ore and metallurgical coal price assumptions in analyst models, which should boost valuations. The structural attractions of medium-grade Pilbara iron ore, as Chinese steel mills try to maintain production while reducing air pollution, should give analysts confidence. Meanwhile, iron ore supply constraints within China are creating room for Australian miners to increase share. The return of cost inflation to Australian mining is an earnings headwind but should also steepen cost curves, which advantages lowest-cost miners able to find offsetting productivity gains. BHP is one.
We value BHP shares at $35.50, so the shares are undervalued without being cheap. The ordinary dividend yield is five per cent fully franked and there will probably be at least one large off-market buyback with a fully franked special dividend component as the $10.9 billion of shale proceeds are returned to shareholders. Below $31.00 looks like an entry point where investors are compensated for mining equity risk.
Clime Group owns shares in BHP
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